How to Determine Indirect and Direct Labor Expenses Using Utilization Ratios

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What is Utilization Ratio?

The utilization rate is an important ratio that companies can use to charge their clients. The ratios are used for maximizing the productivity time for employees. It can reflect the effectiveness of billing and the overall productivity of the company. There are two different types of methods used in bookkeeping for calculating indirect and direct labor expenses utilization ratios.

Method One

The first method is used for calculating the total billable hours divided by the number of hours recorded in a particular time period. For example, if the total hours are 60 but the hours billable are 30, then the utilization rate would be 30/60 = 50%. Using this utilization ratio, if the company is willing to cease recording their non-billable time, the ratio will always be equal to 100%.

Method Two

The second method used for calculating labor utilization rate uses the total hours billable divided by a fixed number of hours for each week. An example will help elaborate this formula. If there are 22 billable hours recorded in a predetermined 40 hours per week, then the utilization ratio will be calculated as 22/40 = 55%.

Why are Labor Utilization Ratios Important?

Company leaders rely on utilization ratios to significantly identify how much of the company’s workforce is currently employed and productive. It provides how the current workforce is performing and the required performance from current employees. If the ratio indicates an overproduction, then the company must hire more people to improve and balance productivity based on utilization rates.

Direct Labor Utilization

A company’s payroll is considered the largest organizational expense. Companies want to make sure that their payroll costs are generating sufficient income. Direct labor utilization ratio indicates how much a company is spending each year for direct labor.

The remainder payroll associated costs are considered as indirect labor costs. Examples of indirect labor costs are:

  • Amount spent on training employees
  • Administrative expenses
  • Marketing expenses
  • Paid vacations
  • Taxes

How to Calculate Direct Labor Utilization Ratio

The calculation needed for direct labor utilization ratio includes: dividing the total payroll amount associated with direct labor by the total cost of payroll for that specific period which will give the direct utilization ratio. For example, if your company is spending $4000 on the payroll for a specific pay period and pays an additional $3000 in direct labor expenses, then the utilization ratio for direct labor is 75%. (3000/4000 = 75%)

On average, the direct labor utilization ratio must be around 65%. A value higher than 65% will indicate that the company is utilizing its labor force efficiently. Companies that have less paid vacations and paid training will have a lower utilization cost.

Indirect Labor Utilization

Overhead costs are also called indirect labor costs. Labor overhead costs are directly associated with the different materials used for direct labor. Calculating indirect labor utilization is different and here’s what we need:

  • The number of hours an employee has worked: if the employee worked for 52 weeks per year * 40 hours per week, then he/she worked for almost 2,080 hours.
  • Deduct the total time spent on holidays per year: 45 days or 360 hours (including sick leaves, public holidays, training and seminars) 360 – 2,080 =1720 hours

Hence, the 1720 hours is our total hours spent by one employee as indirect labor utilization.

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